Choosing an FHA vs. conventional mortgage loan comes down to your credit. Conventional loans are more common and usually cheaper for most borrowers if they have good credit and a down payment of 20%. An FHA loan makes sense for borrowers, especially first-time homebuyers, who might have a hard time qualifying for a conventional loan. This guide can help you determine which loan suits you best.
What is an FHA loan?
An FHA loan is a type of mortgage insured by the Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development (HUD). A private mortgage lender originates the loan, making sure you and the property meet the requirements set by the FHA. The lender then sells the mortgage on the secondary market.
Since the FHA insures the loan, it covers the lender’s losses if a borrower defaults. This guarantee means many borrowers are able to get mortgages with better interest rates and lower eligibility requirements than they would find on the open market.
FHA loans could make sense for borrowers with:
- Lower credit scores
- Recent bankruptcy
- Past foreclosure
- High debt-to-income ratios (DTI)
- Low down payment
- Employment gaps
What is a conventional loan?
A conventional loan is a mortgage that’s not part of a government-backed mortgage program, such as FHA, USDA, or VA loans. Conventional loans are available in both conforming and non-conforming types.
Conforming loans
Conforming loans meet standards set by the Federal Housing Finance Agency, which establishes which loans can be sold to Fannie Mae and Freddie Mac. One key requirement is the loan limit, which sets a maximum purchase price by location.
Conventional conforming loans also typically have more stringent requirements to reduce risk to the lender. Exceeding minimum down payment, DTI and credit requirements usually translate into better mortgage rates.
Conventional loans could make sense for borrowers with:
- Higher credit scores
- Lower DTI
- Steady employment
Qualifying for a conventional loan can be harder than getting an FHA loan due to the stricter credit score and DTI requirements.
Non-conforming loans
Non-conforming loans aren’t standardized and vary by lender. Because they can’t be purchased by Fannie Mae or Freddie Mac, they pose more risk to lenders and are usually much more expensive. These can include:
- Loans above the loan limit, such as jumbo loans
- Loans for customers with assets and cash but little income
- Loans for properties with unique features, such as farmland
- Loans for self-employed borrowers
What are the key differences between FHA and conventional loans?
FHA loans aren’t just for borrowers with low credit scores and conventional mortgages aren’t just for people with higher down payments. Here’s a chart illustrating important differences between FHA and conventional loans:
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How do credit score requirements differ between FHA and conventional loans?
One of the biggest differences between FHA and conventional loans is the credit score requirement. At a minimum, this is what you’re looking at:
- FHA minimum credit score: 500
- Conventional minimum credit score: 620
FHA has more flexible credit qualifications, allowing a credit score as low as 500 if you’re able to make a 10% down payment. With a credit score of 580, you’re able to make a down payment of 3.5%. A conventional loan typically requires a credit score of at least 620. A good FICO credit score is 670 and above, and can help you qualify for better interest rates.
An FHA loan also allows borrowers who previously had a bankruptcy or foreclosure be able to qualify for a mortgage sooner. The waiting period is a minimum of 12 months for Chapter 13 bankruptcy and two years for a Chapter 7 bankruptcy.
Keep in mind:
You’re likely to get a better interest rate if you have a higher credit score. If you just barely meet the minimum requirements for a conventional mortgage, it might come with a higher interest rate.
How does mortgage insurance differ between FHA and conventional loans?
Conventional and FHA loans both use some type of mortgage insurance to protect the lender in case the borrower defaults. If you take out an FHA loan, you’ll pay a mortgage insurance premium (MIP), often for the entire loan term. If you make at least a 10% down payment initially, you can have MIP removed after 11 years.
Conventional loans have private mortgage insurance (PMI), and it’s not required for every loan. PMI is typically only needed if you make a down payment of less than 20%, but you can request to remove it when your remaining loan balance is 80% of the original amount. It can also be automatically removed when the balance owed drops to 78%.
The actual cost of PMI varies, but it’s typically around 0.5% to 1% of your loan amount. For example, if you took out a $350,000 loan with an annual insurance premium of 0.8%, you’d need to pay $2,800 per year.
With MIP, you pay both an upfront fee of 1.75% of the loan amount and an annual premium between 0.45% and 1.05%. So, if you borrowed $350,000 with an annual premium of 0.8%, you’d pay $6,125 upfront and $2,800 per year.
Which loan is better for first-time homebuyers?
The best loan is the one that gives you the best terms based on your financial situation. While FHA loans are often considered a better option for first-time homebuyers, that’s not always the case. Here are some situations where each loan might make sense for first-time homebuyers.
FHA loans are beneficial for first-time borrowers with:
- Lower credit scores
- Recent bankruptcy
- Higher DTI
- At least a 3.5% down payment
- A multi-unit property with a lower down payment
Conventional loans are a good choice for first-time homebuyers with:
- Good credit, typically 670 or higher
- At least a 3% down payment
- Lower DTI
- Other low-risk factors
If you have a lower credit score, a recent bankruptcy, or a higher DTI, an FHA loan might be the least expensive route. If you want to finance a multifamily property, either loan type could be a good choice. FHA loans allow a 3.5% down payment on properties with between one and four units. Conventional loans require at least 5% for financing two- to four-unit properties.
For many first-time homebuyers with good credit, a conventional loan could be less expensive. Here’s why:
- You can get out of mortgage insurance sooner: Unless you make a 10% down payment and pay your FHA loan for 11 years, you’d likely have to refinance to remove MIP.
- Fewer fees: Conventional mortgages come with fewer fees and lower costs. The upfront fee for mortgage insurance on an FHA loan at 1.75%, in particular, is a large fee you have to cover in addition to closing costs.
- Better annual percentage rate (APR): The upfront fees you’ll pay for an FHA mortgage can raise your APR. You can usually get a better interest rate with a conventional mortgage because you don’t have an upfront insurance premium and other fees.
- Less stringent home inspection requirements: When you buy a home with an FHA loan, it needs to meet minimum property requirements, which are a set of standards the home needs to meet (as determined by an FHA-approved appraiser). While conventional mortgages also require an appraisal, they don’t have the strict requirements that an FHA loan does.
Pros and cons of FHA vs. conventional loans
If you’re deciding between an FHA vs. conventional loan, make sure you know the benefits and drawbacks of each. Here’s a quick rundown of the pros and cons of FHA loans:
FHA loan
Pros
- Down payment as low as 3.5% (including 1 to 4 units)
- Credit score as low as 500
- Debt-to-income ratio up to 57%
Cons
- Can have a higher APR
- Higher upfront fees
- MIP often required for entire loan term
- Lower loan limits
Here’s what to consider before taking out a conventional loan:
Conventional loan
Pros
- Higher loans limits
- Down payment on a single-family property as low as 3%
- Down payment on a 2- to 4-unit property as low as 5%
- Lower APR
- Lower fees
- Mortgage insurance can be removed
Cons
- Higher credit score requirements
- Higher costs for borrowers with lower credit scores
- May need to pay mortgage insurance with down payments lower than 20%
- May not allow you to roll closing costs into the loan
Disclosure: Depending on loan type, different lenders in the United States offer loans to consumers with credit scores as low as 620, 580, or even 500. Lenders listed in the Advertisements that appear in this article are unlikely to offer loans for consumers with credit scores below 620.
FHA vs. conventional loan FAQ
Can I switch from an FHA loan to a conventional loan?
If you want to switch from an FHA loan to a conventional loan, you’ll need to refinance your mortgage. This involves taking out a new mortgage with credit, income, and property qualifications. You’ll need to pay closing costs for the new home loan, which can be between 2% and 5% of the loan amount, so make sure you’ll benefit from refinancing.
How does mortgage insurance differ between FHA and conventional loans?
Mortgage insurance with FHA is called mortgage insurance premium (MIP) while mortgage insurance on a conventional loan is called private mortgage insurance (PMI). PMI is usually required on a conventional loan with a down payment of less than 20% and is automatically removed when the principal amount of the loan reaches 78%. MIP is required on all FHA loans and has few scenarios where buyers can remove it.
What are the loan limits for FHA vs. conventional loans?
FHA loan limits for a single-family home in most counties across the U.S. is $498,257. For high-cost areas, the limit is $1,149,825 and for Hawaii, Alaska, Guam and the Virgin Islands, the limit is $1,724,725. Conventional loan limits are $766,550 in most areas and $1,149,825 for Hawaii, Alaska, Guam, the Virgin Islands and many high-cost areas.
